J.W. Verret is Associate Professor at George Mason University Antonin Scalia Law School and Managing Director of Veritas Financial Analytics LLC. This post based on a survey report that Professor Verret designed in collaboration with Spectrem Group, available here.

As the SEC continues its consultation into the proxy process, in particular its consideration of the role of proxy advisory firms in that process, it’s more important than ever to understand how this process affects average retail investors and what, if any, changes they’d like to see. To that end, I collaborated with wealth management research specialist Spectrem Group, to design a survey of retail investor to hear directly from the ultimate stakeholders of proxy voting.

This survey of more than 5,000 retail investors—including those accessing the capital markets through pension funds or private retirement accounts—reveals that retail investors are indeed concerned about the growing influence of the proxy advisory firms and that their concerns are only magnified as they learn more about this opaque part of the proxy process.

Below are the recommendations provided within the report—which can be accessed here.

Recommendations

1. Conflicts of Interest at Proxy Advisors

In determining what regulatory steps to take, it’s worthwhile to reiterate “those who have put or are putting $50, $100, $200 a month away for years and years” are the most critical audience of consideration. This survey provides a rich resource for the SEC by soliciting views on the issue of proxy advisors directly from retail investors.

If ISS and Glass Lewis were conflict free, offered robust recommendations based on increasing shareholder value and did not obtain demand for their services in part through regulatory pressure, then there would be little reason for the Commission to take action on these issues. Unfortunately, that is not the case.

Conflicts of interest at the two dominant firms in the proxy advisory industry manifest themselves in two primary ways. The first and more subtle conflict is the influence of proxy advisors’ clients on the recommendations issued. Substantial income is provided by “socially responsible” investing funds to proxy advisors, which are in turn incentivized to favor proposals that are backed by these clients. When retail investors were apprised of this problem, they strongly demanded responsive action from the Commission.

These conflicts of interest are exacerbated by the level of market power the top two firms enjoy. Retail investors expressed concern about this as well. Twenty-nine percent of participants expressed some familiarity with the dominant proxy advisory firm, ISS. Fifteen percent expressed some familiarity with the second-largest proxy advisor, Glass Lewis. When told that some are concerned that ISS and Glass Lewis represent a duopoly in the market, limiting new competitor entrants, an overwhelming 76 percent of respondents expressed some level of concern.

While it would not be appropriate for the SEC to directly regulate the market share of proxy advisory firms, this research does suggest retail investors would welcome Commission attention to rules that may entrench the dominant position of these firms, in addition to devoting attention to conflicted advisory fees that further cement the dominant position of ISS in the market.

The current dynamic for proxy advisors deviates from a focus on shareholder value, generating private benefits to a subset of investors at the expense of the average diversified investor. This has implications for another of the roundtable’s areas of focus: the role of shareholder proposals in the proxy process. In effect, proxy advisors have been granted the ability to wield the aggregate influence of their clients to the benefit of a particular type of investor—potentially at the expense of the interests and expectations of retail investors.

The second and more obvious conflict that exists in the proxy advisory industry is the provision of consulting services to the same issuers about which recommendations are issued to investors. The implicit threat of receiving a negative recommendation from ISS is a cornerstone of the offering from that same company to publicly listed companies.

There are analogous concerns over conflicts of interest in other areas of financial services, particularly those stemming from the provision of consulting services. The investment community itself (including the Council for Institutional Investors and California Public Employees’ Retirement System) has been steadfast in arguing against the provision of consulting services by a company’s external auditor. Simply disclosing and “mitigating” the existence of a material conflict would not be seen as acceptable to auditors or credit rating agencies; it is unclear as to why it is sufficient for the proxy advisor industry. A proxy advisor simultaneously providing governance advisory services and recommendations is akin to an auditor providing an issuer with guidance on how to navigate an external audit.

The retail investor survey shows that retail investors do not take the same “see no evil, hear no evil” approach to conflicts of interest at proxy advisory firms, but instead quickly see the case for addressing conflicts of interest at proxy advisors and would welcome Commission action to address this issue. While additional disclosure about conflicts of interest may prove helpful, the substantial market power given to ISS through prior Commission action suggests prohibition may be warranted for conflicted consulting provision by proxy advisors.

The concerns of retail investors are compounded by their relative lack of involvement in the proxy process. Only 50 percent of respondents, 2,567, had ever voted their shares, though 68 percent expressed some level of interest in voting their shares in future meetings. Forty-nine percent responded that they wanted more information from asset managers on how shares are voted; only 33 percent suggested current vote disclosure by asset managers was sufficient.

This result is consistent with the notion that retail shareholders don’t tend to see active voting as beneficial. At the same time, when made aware of the potential that shares may be voted on their behalf in ways that conflict with their interest by asset managers, retail investors would prefer additional disclosure.

2. Proxy Advisor Disclosure

The objective of corporate governance is the enhancement and protection of shareholder value; however, it remains unclear what role shareholder value plays in the processes and methodologies of proxy advisors. In fact, the evidence appears to point to the contrary, as a lack of capacity and capability, conflicts of interest and ideological bias result in proxy advisor recommendations by ISS and Glass Lewis depleting shareholder value.

The retail investor survey shows that the social and political focus of many proxy advisory firms is inconsistent with the shareholder return focus of most retail investors. Further, many investors are eager for disclosure about how these conflicts of interest may be impacting their portfolios.

In two separate Stanford University studies, [1] researchers found that the recommendations of ISS negatively impacted shareholder value, with investors better off ignoring ISS. ISS also promulgates other corporate governance policies for which the empirical evidence is mixed, at best, including the right to nominate director candidates to the corporate proxy, [2] options repricing, [3] independent chairs [4] and Golden Parachutes. [5] While these policies are certainly favored by politically minded institutional investors—ISS’s largest clients—they are not clearly linked to the enhancement of shareholder value and thus stronger returns to the ultimate beneficiaries of mutual funds.

In many ways, it would be unreasonable to expect the two dominant proxy advisors to be effective in providing accurate and nuanced corporate governance advice to investors. ISS’s website states that it covers over 42,000 meetings a year for a client base in excess of 1,700, while Glass Lewis produces analysis on more than 20,000 companies. The combination of minimal resources and significant influence is cause for concern and should provide an impetus for greater SEC oversight in order to protect investors.

By policy, Glass Lewis does not provide issuers with any opportunity to review recommendations and is only piloting their RFS process, while ISS limits the opportunity to only the largest companies in the United States. Eighty-one percent of survey respondents expressed some level of concern when presented with a study suggesting that major proxy advisors did not provide issuers with an opportunity to comment on adverse proxy recommendations in 84 percent of cases.

This concern from retail shareholders is unsurprising—ISS itself accepts that the review process is of benefit to multiple stakeholders:

“ISS believes that this review process helps improve the accuracy and quality of its analyses, an outcome that is in the best interests of both the institutional investors for whom the analyses are prepared, as well as for the companies that are the subject of these reports.” [6]

BlackRock, the world’s largest asset manager, also expressed a preference for the SEC to explore technology solutions such as a digital portal for the review of draft company reports, which would provide companies with at least two business days to correct errors prior to the report’s publication to shareholders and allow companies to submit a rebuttal to be included in the final report. [7]

When asked how much time issuers should be granted to review proxy advisor recommendations and remedy potential errors, the largest share of respondents (29 percent) suggested an appropriate time period to be between one and two weeks. Seventy-nine percent of respondents expressed some level of support for the SEC addressing the concern that proxy advisors fail to engage with issuers.

With over half of U.S. annual general meetings taking place in a three-month period, both advisors must, by necessity, put in place rigid methodologies in order to produce the volume of reports they do. The problem with rigid methodologies is that they simplify the complexities of business reality and do not allow for case-by-case appraisals of company practices and disclosure.

The inability of the two dominant proxy advisors to offer company- and circumstance-specific recommendations, and the limited empirical evidence supporting those recommendations, calls into question whether ERISA and mutual fund fiduciaries are fulfilling their obligations in relying on the proxy advisor advice of ISS and Glass Lewis.

Eighty-four percent of respondents stated they were concerned with the practice of robo-voting, with only 3 percent of investors failing to indicate support for the SEC to address this issue. Eighty-six percent of respondents supported SEC action to improve transparency in proxy advisors, and 83 percent of respondents offered some level of support for Commission action to address the problem of errors in proxy advisor recommendations.

Disclosure can only help shine the light on what proxy advisors are actually delivering. Retail investors may have the right idea. Fewer votes on wasteful ballot issues may be the right approach, in which case intermediary institutions will have less need for proxy advisors. This is particularly true when the dominant players in this industry are motivated by conflicts that run counter to the interests and expectations of most retail investors—the ultimate beneficiaries for whom the SEC wants to improve the proxy process.

While there are times when active share voting can generate value for investors, it remains unclear whether that is always the case system-wide. Institutional investors should be able to establish a default voting process that votes with management, absent a clear red flag suggesting further inquiry is necessary. Based on the SEC’s current guidance, it is not clear that institutional investors could establish such a policy. The SEC could remedy that problem with a change in its mutual fund voting guidance.

The Commission observed in its original release that “there may even be times when refraining from voting a proxy is in the client’s best interest, such as when the adviser determines that the cost of voting the proxy exceeds the expected benefit to the client.” While it would appear the Commission is indicating it does not require active voting by mutual funds, in fact the adopting release taken as a whole suggests a presumption in favor of active voting management, with the burden on funds to show that active voting is not beneficial.

A large percentage of shareholder proposals, on which proxy advisors provide recommendations, are defeated. Indeed, in 2017, only 5 percent of all shareholder proposals received a majority vote of support; 95 percent of them were rejected. [8]

The SEC should elaborate on language in its original adopting release to swap the presumption in favor of active voting by management to instead permit fund managers to refrain from voting—unless it is clearly demonstrated that the benefits of actively voting exceed costs. It should instead explicitly permit funds to adopt voting policies that reflect the lack of value in many voting contests. Asset managers should be able to adopt policies that eschew voting in general in instances of shareholder proposals, or adopt policies tailored to vote with management unless red flags listed by the fund’s management are triggered (such as a recent restatement).

An externality of the SEC’s interpretation is the prevalence of robo-voting, an issue cited by retail investors as the most concerning. By appearing to remove the ability of institutional investors to adopt policies that allow for defaulting their vote in favor of management, regulatory guidance has channeled the collective influence of those same investors into the hands of two proxy advisors—neither of which owns a single share in a public company nor has a fiduciary obligation to any retail investor. In practice, through robo-voting, investors can default voting to proxy advisors but not to management.

The Commission should also make clear that if fund managers adopt voting policies intended to further political or social causes important to the fund’s managers or controlling shareholder—which have not been shown to enhance shareholder value—those fund managers may violate their fiduciary duties to the fund’s beneficiaries.

These conflicts could be manifested in many ways, including informal pressure during board elections or merger approvals. The most direct way they appear is via shareholder proposals, most of which are fairly characterized as displays of personal, political or social policy preferences with little relationship to shareholder value. Proxy Monitor observes that “proposals related to social or policy concerns with a limited relationship to share value constituted 56 percent of all shareholder proposals in 2017.” [9] Given that institutional shareholders and the proxy advisors they employ should vote their shares in line with the interests of their clients and retail investors, the onus to clearly articulate a link between any proposal and shareholder value should set a high bar. Proxy Monitor tracks that from 2006 through 2015, companies received 1,347 shareholder proposals related to social or political matters. None of those proposals received a majority of shareholder support, [11] yet they place a cost on companies and other shareholders.